Basics of Home Equity Loans

How Do Home Equity Loans work?

Home equity loans are increasingly popular because they are cheap and easy to get. Home equity loans allow you to borrow money against the equity you’ve accumulated in your home, up to predetermined limit. The lender either gives you on lump sum of money (term loan), or it sets the money aside for you in a reserve account (home equity line of credit) that you can use at any time.

The lender offers the credit based on your home's equity and your credit rating. Most lenders will give you a home equity loan that equals anywhere from 50 to 85 percent –-sometimes even 100 percent -- of your home’s value minus the amount of your existing first mortgage.

< Example>
Your house is appraised at $250,000.
If the lender uses 80% LTV (loan-to-value), your available equity is $200,000.   ($250,000 x .80 = 200,000)

If you still owe $100,000 on your mortgage,
then you can borrow up to $100,000 on your home equity loan.   ($200,000 - $100,000 = $100,000)

Note: The maximum amount that you can borrow and the amount that you should borrow are not necessarily the same. In fact, it’s better that you borrow less.

Home equity loans usually have a higher interest rate and shorter term - typically five to 15 years - than first mortgages. However, those rates are usually lower than those of other consumer loans or credit card loans. You will pay back the loan in monthly payments for a set term, which is rather leisurely compared to those of other consumer loans.

However, the utmost risk of taking a home equity loan is that you’re putting your house on the line. Unlike other consumer credits, which are unsecured debts, a home equity loan is secured by the value of your home. You have to pay off the loan in full when the life span of the loan has expired or you sell the house. If you're unable to make the payments and the loan goes into default, the lender may seize your home, which is called “foreclosure.” Remember, even if you pay your mortgage on time, you may lose your house if you default on your home equity loan.